Alarm over price of homes

Kathleen Pender

Remember how the price-earnings ratio for stocks soared before the market crashed?

Well, the price-earnings ratio for homes in the Bay Area and greater Los Angeles is also skyrocketing, according to a forthcoming report from UCLA economist Ed Leamer. He says homes are so overvalued that prices are likely to fall when the Federal Reserve raises interest rates.

A P/E ratio shows how much investors are willing to pay for a dollar of earnings. It is one way to measure the public's enthusiasm for a particular asset class. The higher the ratio, the greater the zeal.

In the stock market, you calculate P/E by dividing a company's share price by its annual earnings per share.

In the housing market, you divide the price of a house by the annual rent it could fetch.

Leamer calculated the average P/E for homes in several California metro areas by dividing the median price for a single family home by the average annual rent for a 2,000- square-foot apartment in each region. (You can get more and better data for apartments than rental homes, and the two tend to track each other.)

His findings: In the Bay Area, the average P/E for a house shot up to 13. 8 in the first quarter of 2004, compared with 7.2 in 1999 and 2000. Today's ratio is more than a third higher than it was 1989, just before housing prices started a multi-year descent.

In Santa Clara County, the average P/E is 15.8 today, compared with 10.3 in 1989.

"We are in a situation that is more extreme than it was in 1989," says Leamer, director of the UCLA Anderson forecast.

In the Bay Area, P/E ratios are skyrocketing because rents are falling while home prices are escalating, Leamer says.

In San Francisco, the average rent has skidded to $22.01 per square foot from $31 per square foot in 2000, while the median home price has risen to $606,000 from $450,755.

In Southern California, where the economy is stronger and more diverse, rents are rising, but housing prices are rising even faster. As a result, P/Es are also rising, though not quite as far as in Northern California.

In Los Angeles, the price of a median home rose to $399,000 in the first quarter of 2004 from $215,652 in 2000. Rents rose to $19.35 per square foot from $18.07.

When the economy is booming, investors are willing to pay higher prices for stocks and houses because they think the earnings from these assets will grow faster than normal. Occasionally, they throw common sense out the window and start believing that earnings will continue upward in a never-ending spiral, untouched by forces like competition and economic equilibrium.

That is what happened to the stock market and tech stocks in particular in the late 1990s and early 2000. In March 2000, Cisco was trading at 192 times earnings. Today, it is trading at 35 times earnings.

When the economy cooled in 2000, stock prices started coming down, but housing prices continued to go up because falling mortgage rates had made homes more affordable.

"The elevated P/E ratio didn't come from the strength of the economy. It came from low mortgage rates. That's great if it is a permanent new condition. We know it's not true," Leamer says.

In a 2002 paper, Leamer warned about rising P/E ratios for homes, but did not see the bubble bursting "in the immediate future." But, he warned, "this could turn around rapidly if Mr. Greenspan decides to increase short-term interest rates."

In closing, he wrote, "Stay tuned. I promise to keep you informed of any breaking developments in this regard."

With the Fed likely to raise short-term interest rates this summer, Leamer says now is the time to worry about a bursting bubble.

On Tuesday, Federal Reserve Chairman Alan Greenspan downplayed the bubble theory, but told senators, "We perceive that the very strong expansion in new and existing home sales is now flattening out. And the really quite unexpected boom in home sales over the recent years is unlikely to be continued. Our forecast is generally flat, not in prices but in aggregate volumes. Where house prices go, I'm not sure, but I would be quite surprised if they showed continued acceleration on the upside."

Leamer says the best-case scenario for housing is that price appreciation slows or stops. This would require the economy to grow rapidly with relatively little inflation so people could still afford homes, even with a modest increase in interest rates.

In the worst-case scenario, "inflation starts becoming more apparent, and long-term interest rates elevate much more rapidly or substantially."

In this case, higher interest rates not only make mortgages more expensive, but also choke off the economy, leaving fewer people able to afford homes. Higher rates also make bonds and money market funds relatively more attractive than real-estate investments. As a result, housing prices fall substantially.

The most likely scenario, in Leamer's view, is that "we have another recession in 2006, with significant problems in the housing sector."

At a home-building conference in San Francisco Wednesday, Ken Rosen, chairman of UC Berkeley's Fisher Center for Real Estate and Urban Economics, called the current P/E ratio for Bay Area housing unsustainable.

He predicts that gradually rising rates will make purchasing a home less attractive than renting for many people. That will lower house prices, increase rental prices and bring the P/E ratio more in line with long-term averages.